The problem with P-Notes, why tackling them has proved tricky

With more broadbased flows and greater global pressure now on checking illicit fund flows, it should be possible to phase out PNs over the medium term.

With more broadbased flows and greater global pressure now on checking illicit fund flows, it should be possible to phase out PNs over the medium term. (Reuters)

The Sensex slid over 500 points on Monday following a recommendation by the Supreme Court-appointed SIT on black money, that rules on Participatory Notes be tightened, and that Sebi track the beneficiaries of these investments. What are P-Notes, how have they impacted the markets, and what could the latest move spell? SHAJI VIKRAMAN gives the lowdown.

What are Participatory Notes (or P-Notes, as they are commonly referred to)? In 1992, India allowed Foreign Institutional Investors (FIIs) to buy stocks listed on Indian exchanges. However, all investors, whether institutions or individuals, were required to register themselves with the capital markets regulator, Sebi. To get around these restrictions, FIIs started to issue so-called participatory notes (or PNs) to investors who, for various reasons, wanted to remain anonymous. PNs were essentially Overseas Derivative Instruments (or ODIs) that had Indian stocks or derivatives as their underlying securities, with the holder entitled to the income or capital appreciation from such investment. The practice was sort of legitimised during the tenure of D R Mehta as Sebi chairman, after a High Level Committee on Capital Markets in 2002 allowed sub-accounts of FIIs to issue such contracts.

Since PNs tracked the value of Indian stocks, their values rose or fell according to the movement of the markets. Initially, nobody complained, as FIIs generated a lot of business from monies routed through them and their accounts. These monies fuelled the market boom from the early period of liberalisation. At their peak during 2007, the value of PNs constituted well over 50 per cent of the outstanding assets in the custody of FIIs.

What has the SIT on black money said? Why is the stock market worried?In its third report, contents of which were released on Friday, the SIT recommended that the government should obtain details of beneficial ownership — or identity of the final holder or investor — of P-Notes, and make it non-transferable. The SIT wants investors’ due diligence — or KYC — details to be known to the regulator. It has also made the point that a bulk of P-Notes investments were from overseas jurisdictions such as the Cayman Islands, a tax haven that accounted for 31 per cent of all foreign inflows from offshore derivative instruments. The worry is on account of the fact that the outstanding value of PNs at the end of February 2015 was 2.715 lakh crore — which, if unwound, can lead to carnage in a market where local institutional investors are not as influential. Finance Minister Arun Jaitley has, however, assured that there would be no kneejerk reaction.

What are the broad concerns about P-Notes?Concerns have been expressed over anonymous investors who are beyond the reach of Indian regulators or taxmen, and over indications that wealthy Indians, including promoters of Indian companies, have been using this route to bring back unaccounted funds and to rig their stocks. The concerns were first flagged by the Joint Parliamentary Committee on the 2001 securities market scam, which said that P-Notes enabled their holders to conceal their identities. The committee also pointed to the links that stock market player Ketan Parekh had with foreign entities, which allowed him to allegedly rig stocks, and to the role of Overseas Corporate Bodies or OCBs owned predominantly by Indians in the stock market crash. The JPC wanted action on these issues.

What follow-up action was taken?Within weeks of taking over as RBI Governor, Y V Reddy used the JPC recommendations to ban, on September 16, 2003, fresh investments in stocks and other products by OCBs. In his effort to prevent the banking system from being used as a conduit for black money, Reddy cut off a source of flows to the Indian market, and left an enduring impact. Apparently, the RBI was then given to understand that Sebi, led at the time by G N Bajpai, would take steps to ban P-Notes.

The Sebi board approved it — but for reasons that remain unclear, the ball was passed to the NDA government led by Atal Bihari Vajpayee, which sat on it. Subsequently, as foreign fund flows started accelerating, the central bank again sought a ban on P-Notes, pointing to the lack of regulation and the difficulty in identifying the nature of beneficial ownership. The problems with the investments’ multilayered nature were subsequently brought out in investigations by Sebi and the tax authorities. The other worry was of course, the volatile nature of such flows, which impacts the rupee, financial stability and the larger economy — and leaves Indian markets vulnerable to short-term fund flows.

What has Sebi done so far to regulate P-Notes? In 2004, Sebi tightened rules to ensure PNs were issued — and transferred — only to regulated entities. On October 16, 2007, against the backdrop of a surge in capital flows and excess liquidity, the regulator banned P-Notes. M Damodaran was Sebi chief then, and P Chidambaram was Finance Minister. The markets crashed immediately, but recovered after the regulator unveiled rules a week later, saying FIIs could not take any fresh exposure, and their existing investments would have to be wound up in 18 months. But exactly a year later, during the tenure of Damodaran’s successor, C B Bhave, all restrictions on PNs were removed in the wake of the global financial crisis, amid fears of capital outflows. But rules were tightened again subsequently. From January 2011, FIIs have had to provide an undertaking that they have followed KYC norms, and submit details of transactions. In 2014, new rules on Foreign Portfolio Investors made it mandatory for those issuing PNs to submit a monthly report disclosing their portfolios, after which the number of entities issuing these has come down. Allowing overseas individual investors entry in 2012 also helped change the environment.

Why is it difficult to ban P-Notes?The RBI may be pushing hard, but the government, which has the final say in foreign investment rules, appears to be reluctant to impose a full ban, presumably because of a fear that the stock markets would tank, and there would be a flight of capital. With FIIs now controlling 20 per cent of the free float in listed Indian companies, policymakers would want to think several times, especially in a country which runs a current account deficit and needs foreign investment to bridge the gap in savings.

During the UPA government’s tenure, a committee headed by the then Chief Economic Advisor, Ashok Lahiri, released a report in November 2005 on encouraging FII flows and checking the vulnerability of capital markets to speculative flows. The committee suggested measures such as greater broadbasing of foreign entities investing in the Indian market, and a ceiling on FIIs and their sub-accounts. The majority view, however, was that the existing dispensation for PNs ought to continue. In a move that was rare for a situation in which a government-led panel was involved, the RBI dissented, arguing that PNs should not be permitted because it remained difficult to identify their final holders.

So, what policy options are available on PNs?With more broadbased flows and greater global pressure now on checking illicit fund flows, it should be possible to phase out PNs over the medium term. That is, if it is grandfathered — or, in other words, spread out over a specified period with a sunset clause. That should go hand in hand with reforms in taxation, including greater clarity, easier norms, lowering of transaction costs, and encouraging more local institutional investors — especially pension funds and FDI — to reduce reliance on volatile flows.